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Portfolio Commentary

Review and Outlook (for quarter ended 12/31/2014)

The fourth quarter was extremely challenging for Baron Energy & Resources Fund as the sharp decline in oil and gas prices that began around mid-year accelerated, precipitating steep declines in share prices across the energy spectrum. In the second half of the year, as the U.S. dollar strengthened and the European, Japanese, and Chinese economies weakened, global oil demand expectations weakened as well. At the same time, supplies were boosted by a rebound in Libyan and Iranian oil production, along with growth in U.S. oil supplies. When in late November, Saudi Arabia decided not to cut production to restore the supply/demand imbalance, oil prices went into free fall.

The Fund contracted by 20.8% in the quarter and finished the year down 12.8%, compared with declines in WTI oil prices of 41.6% and 45.9%, respectively. So while the Fund did better than oil, the sharp decline in oil prices was still the major driver of share price performance. Prior to the fourth quarter, the Fund’s correlation to oil prices was relatively low, with an R-Squared of less than 28%. However, in the last three months, the correlation jumped to 50%, which is not surprising given the magnitude of the decline in oil prices and the negative ramifications that low prices will have on company profits and growth potential.

The fall in oil prices also has had a disproportionately negative impact on smaller cap companies and companies with higher debt levels. While our Fund generally avoids highly leveraged companies, our concentration in small and mid-cap exploration & production and oilfield service & equipment companies hurt performance. On the positive side, Midstream/MLP-oriented companies did not decline nearly as much. A higher-than-average weighting toward this sector has been a key part of our risk management strategy and while we lost money in these stocks this past quarter, it appears this part of our strategy was a success.

We did not make major overt changes to the portfolio in the quarter. Most changes resulted from performance differences among sub-segments of the Fund. We did boost our holdings of renewable energy companies and Midstream/MLP stocks. We have been increasing our exposure to renewable energy companies that develop and own utility scale and commercial solar and wind projects. As these technologies have reached “grid parity” on an unsubsidized basis in many markets around the world, demand for renewable energy projects is growing very rapidly.

Our near-term outlook will largely be a function of what happens in the oil market. If our assumption is correct that oil markets will stabilize over the next six months and begin to rebound in the second half of the year, we would expect a strong rebound in energy share prices, especially of small and mid-cap companies. Nevertheless, the next several months are likely to be volatile. Longer-term, we still expect that oil prices will revert to a more “normalized” level of perhaps $70-90 per barrel, which is what we believe is needed to offset production declines and generate incremental supply growth to meet future demand. In this environment, we still favor U.S. unconventional oil and gas producers, midstream MLPs, and, to a lesser extent, oilfield service & equipment companies.

Contributors(for quarter ended 12/31/2014)

Dominion Midstream Partners, L.P. is a midstream energy MLP that was spun off from its parent company, Dominion Resources, Inc., in October 2014. Shares rose post-IPO as investors sought energy companies with stable cash flows and visible growth.

RSP Permian, Inc. is an independent E&P company focused on the Permian Basin in West Texas. RSP went public in January 2014 and the shares generated a positive return from the IPO price despite the sharp decline in oil prices since mid-year. RSP has a strong balance sheet and a concentrated set of assets in the core of the basin that we believe will generate excellent economic results and growth in a more “normalized” oil price environment.

Detractors(for quarter ended 12/31/2014)

Bonanza Creek Energy, Inc. is an independent E&P company focused primarily on Northeast Colorado. Shares declined sharply in Q4 amid the rout in oil prices and concerns about the company’s ability to profitably invest in its properties given declining cash flows. While Bonanza’s balance sheet is relatively strong, the significant uncertainty in future cash flows has created concerns about its financial flexibility. Bonanza also concluded its CEO search in Q4 and the initial investor reaction was poor, although we think that reaction is misguided.

SM Energy Co. is an independent E&P company with operations that are primarily focused on shale oil fields in South Texas and North Dakota. The company’s shares fell by 50% during the quarter amid the rout in oil and gas prices. Despite the fact that SM has one of the stronger balance sheets in the sector and that changes in its well completion practices are yielding higher per well productivity and returns, the shares seemed to succumb to a tsunami of selling in the quarter. We exited out position.

Oasis Petroleum, Inc. is one of the largest E&P companies in the Williston Basin Bakken shale oil play. Falling oil prices pressured shares in Q4, as reduced cash flow forecasts led Oasis to curtail investment spending and growth outlook. Oasis’s financial flexibility has also been an investor concern. We believe Oasis has ample financial flexibility, but shares remain levered to oil price changes as economics in the Williston basin become increasingly marginal. We exited our position.

Quarterly Attribution Analysis (for quarter ended 12/31/2014)

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

The Baron Energy and Resources Fund (Institutional Shares) declined 20.84% in the fourth quarter and trailed the S&P North American Natural Resources Sector Index by 698 basis points.

The Fund is more focused on small and mid–cap energy companies than large-cap energy companies, such as integrated oils, and this bias was the primary reason for its underperformance during the quarter. Small-cap energy stocks suffered disproportionately in the quarter, as the steeper-than-expected plunge in oil and gas prices heightened investor concerns about debt levels among some of the smaller companies in the industry. The Fund generally avoids these highly levered companies, but this did not prevent some of its holdings from declining in tandem.

The Fund’s larger exposure to the oil & gas storage & transportation sub-industry within the Energy sector, its average cash exposure of 4.3% in a difficult period for energy stocks, and the outperformance of its renewable energy investments contributed the most to relative results. With over one third of the Fund’s Energy exposure in the oil & gas storage & transportation sub-industry, its larger exposure to this outperforming sub-industry aided relative results. Most of the Fund’s investments in this sub-industry are master limited partnerships (MLPs) and general partnerships (GPs), which investors favored during the quarter because these stocks tend to be less sensitive to oil price fluctuations and offer attractive dividend yields. Strength in the Fund’s renewable energy investments was due to the outperformance of SunEdison, Inc., one of the world’s largest developers of solar energy projects, and TerraForm Power, Inc., a “yieldco” subsidiary of SunEdison. SunEdison is classified as an IT company and Terraform Power as a Utility company. Shares of both companies rose after announcing the transformational acquisition of First Wind Holdings Inc. for $2.4 billion.

Underperformance of the Fund’s investments within the Energy and Materials sectors were the largest detractors from relative performance. Within Energy, the Fund’s oil & gas exploration & production holdings detracted the most from relative performance after falling 31.7% as a group, with small-cap Bonanza Creek Energy, Inc., and mid-cap stocks Oasis Petroleum, Inc. and SM Energy Co., driving the decline. These companies were the Fund’s three largest detractors on an absolute basis during the quarter. Weakness in the sector was also attributable to the underperformance of the Fund’s oil & gas equipment & services investments, led by Superior Energy Services, Inc. The Fund’s lack of exposure to the outperforming integrated oil & gas sub-industry also hampered relative performance. Within Materials, underperformance of Flotek Industries, Inc., a leading supplier of specialized chemicals to the oil & gas industry, and the Fund’s lower exposure to this outperforming sector modestly detracted from relative results. Despite record revenues and strong profits, Flotek’s shares dropped over investor concerns that the drop in oil prices will drive down rig count and well completion activity in 2015.

Yearly Attribution Analysis (for year ended 12/31/2014)

The Yearly Attribution Analysis for period ending December 31, 2014 is not yet available

The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advise to any person and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

You should consider the investment objectives, risks, charges, and expenses of any of the Baron Funds carefully before investing. The prospectus contains this and other information about Baron Funds. You may obtain one from its distributor, Baron Capital, Inc., by calling 1-800-99BARON or click here. Please read it carefully before investing.